The Securities and Exchange Commission (SEC) recently announced other notable examples of the scrutiny being applied to investment advisers’ disclosures of conflicts of interest. The criticism is notably sharp on issues involving fees and costs associated with advisory services.
Of course, there are the well-publicized actions involving the disclosure of 12b-1 fees pursuant to the share class initiative. On March 11, 2019, the SEC announced that 79 investment advisory firms had agreed to return over $125 million to clients in connection with the SEC’s “Share Class Initiative.”
For purposes of this short post, we’ll detail the SEC’s March 5, 2019 regulatory action involving Valley Forge Asset Management, LLC (Valley Forge). The SEC’s action, which resulted in over $5 million in sanctions, centered on Valley Forge’s disclosures to its clients about the brokerage options available to its clients and specifically the costs and services associated with Valley Forge’s own brokerage firm. The action is a reminder of the importance of assessing whether a conflict, or potential conflict, is actually present or just “may” be present. In that regard, we continue to caution that an investment adviser’s use of “may” in connection with conflicts disclosures increases its regulatory risk.
According to the SEC’s March 5th Order, Valley Forge conducted its investment advisory business and brokerage business from the same offices, but it had only a few brokerage-only customers. In other words, the bulk of Valley Forge’s brokerage business was derived from trading conducted on behalf of its investment advisory clients. Valley Forge also offered its clients other options for brokerage services. Notably, Valley Forge disclosed on it ADV Part 2 and in its investment management agreements the following:
- The use of Valley Forge for brokerage services would benefit Valley Forge monetarily;
- The provision of multiple services by Valley Forge “may” be seen as creating a potential conflict of interest;
- “Similar services [by other brokers] may be offered at higher or lower prices elsewhere”;
- If the client chose Valley Forge for brokerage services, the client would receive a discounted “negotiated commission” rate.
These types of disclosures clearly put the clients on notice that utilizing Valley Forge for brokerage services also could result in higher trading costs to the clients and could “be seen as” creating a potential conflict of interest. However, these disclosures were deemed inadequate by the SEC.
In reaching its conclusion, the SEC noted that Valley Forge “was aware” that clients using its brokerage services were paying approximately at least 4.5 times more than under the other options available to Valley Forge’s advisory clients. Finally, the SEC specified that the minimum commission for trades introduced through Valley Forge’s brokerage were more than 2 times the maximum commission charged for trades through another option available to its advisory clients.
In other words, there was little doubt that the clients would incur higher costs if they used Valley Forge’s brokerage instead of the other available options. Thus, while the firm’s disclosure that similar services “may” be available at lower prices elsewhere was not inaccurate, it was inadequate. The disclosure was not sufficient to enable the clients to understand and fully assess the conflicts of interest presented by the Valley Forge brokerage option.
Regulators are challenging the sufficiency of investment advisers’ disclosures on various purported conflicts because of the advisers’ use of “may” instead of language that would more adequately convey the likelihood of a conflict or negative impact on the clients. Other common focus areas include disclosures regarding 12b-1 fees, share class recommendations, and transactions with the firms’ affiliates.
Advocacy efforts have supported a number of clients’ efforts to avoid formal regulatory sanctions. However, there are some key steps investment advisers should take to maximize the odds that their disclosures are deemed adequate and to minimize the sanctions associated with any historical disclosure deficiencies.
- Criticize your existing disclosures through a meaningful self-assessment
- Is the firm or any representative earning non-advisory revenue based on client activity?
- Could clients face higher costs as a result of services/revenue to the firm or its representatives?
- How likely it is that clients will in fact face higher costs?
- Identify all of the manners in which the costs to clients and/or revenue to the firm could impact the advice provided to clients.
- Do the firm’s disclosures accurately reflect the likelihood that such costs will be incurred, revenue will be realized, or the advice could be affected?
- If issues are identified during the self-assessment process, consider remedial measures.
- Return revenue earned as a result of arrangements not adequately disclosed. (Consider doing so even if the revenue did not result in an identifiable cost to client.)
- Amend revenue arrangements to avoid generating conflicts, or the appearance thereof.
- Document your efforts to assess why arrangements that benefit your firm financially are at, or better than, market prices.
- Amend any disclosures that are determined to be inadequate. Consider pushing out the disclosure to clients before the annual ADV distribution.
- Self-reporting to regulators is an issue that is critical to discuss with experienced counsel, but some issues to consider include:
- Extent of potential harm to clients.
- History of regulatory review of relevant practices and disclosures; amount of time since last routine inspection.
- History of complaints or concerns around relevant costs or services.
 One needs to look no further than the actions associated with the SEC’s share class initiative to understand what the regulators expect in this regard.